Chapter 11: Risk and Return

Question 1

Expected Returns

Answer 1

based on the probabilities of possible outcomes

Question 2

Portfolios

Answer 2

=collection of assets

Question 3

Portfolio Expected Returns

Answer 3

• the expected returns of a portfolio is the weighted average of the expected returns for each asset in the portfolio
• weights= % of portfolio invested in each asset

Question 4

Portfolio Risk

Answer 4

-portfolio standard deviation is NOT a weighted average of the standard deviation of the component securities’ risk

Question 5

Returns

Answer 5

Total returns= expected return+ unexpected return

• Unexpected return=systematic portion (m)+ unsystematic portion (e)
• total return= expected return+systematic portion+ unsystematic portion

Question 6

Systematic Risk

Answer 6

• factors that affect a large number of assets

- interest rates represent sources of systematic risk

Question 7

Unsystematic Risk

Answer 7

• risk factors that affect a limited number of assets
• risk that can be eliminated by combining assets into portfolios
• can be reduced through appropriate diversification

Question 8

Principles of Diversification

Answer 8

• can substantially reduce risk without an equivalent reduction in expected returns
• reduces variability of returns
• caused by the offset of worse-than-expected returns from one asset by better-than -expected returns from another

Question 9

Portfolio Conclusions

Answer 9

• as more stocks are added, each new stock has a smaller risk-reducing impact on the portfolio
• forming well-diversified portfolios can eliminate about half of the risk of owning a single stock

Question 10

Total Risk=Stand-Alone Risk

Answer 10

Total Risk= systematic +unsystematic

-total risk for a diversified portfolio is essentially equivalent to the systematic risk

Question 11

Systematic Risk Principle

Answer 11

• there is a reward for bearing risk
• there is NO reward for bearing risk unnecessarily
• the expected return (market required return) on an asset depends ONLY on that asset’s systematic or market risk

Question 12

Interpretation of Beta

Answer 12

-if beta=1.0, stock has average risk
-if beta> 1.0, stock is riskier than average
-if beta < 1.0, stock is less risky than average
-most stocks have betas in the rage of .5-1.5
-beta of the market= 1.0
beta of a T-bill=0

Question 13

Portfolio Beta

Answer 13

Bp= weighted average of the beats of the assets in the portfolio
-Weights (wj)= % of portfolio invested in asset j

Question 14

Beta and Risk Premium

Answer 14

• risk Premium= E(R) - Rf

- the higher the beta, the greater the risk premium should be

Question 15

Reward to Risk Ratio

Answer 15

= [E(Rj)-Rf/Bj]

• in equilibrium ratio should be the same for all assets
• when E(R) is plotted against beta for all assets, the result should be a straight line

Question 16

Security Market Line

Answer 16

• the representation of market equilibrium
• the slop of the SML= reward-to-risk ratio
• slope= E(Rm)-Rf= market risk premium

Question 17

SML and Required Return

Answer 17

-SML is part of the CAPM
-E(Rj)= Rf + [E(Rm)-Rf]Bj
-E(Rj)= Rf +(RPm)Bj
RPm= market risk premium (E(Rm)-Rf)

Question 18

Capital Asset Pricing Model

Answer 18

• defines the relationship between risk and return
• E(Ra)= Rf+(E(Rm)-Rf)Ba
• if an asset’s systematic risk (beta) is known, CAPM can be used to determine its expected return